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September 2011 Investment Journal 


Volatility was the byline for the month just ended. Investors seemed to pivot on a dime and embrace the view that the world economy is slowing sharply. Stock markets and commodities sold off hard, with the S&P 500 shedding 7%, and the DJ-UBS Commodity Index off by almost 15%. Gold was knocked back by 11%, due in large part to increasing margin calls (those who borrowed money betting on higher prices for stocks had to liquidate profitable positions - mostly gold and silver - to pay back their loans). The US Dollar enjoyed a strong month, as it is seen (for now) as the safe harbor, especially with the Euro in such a tempestuous sea of uncertainty. US Treasuries were the natural beneficiary of this rotation out of "risk", with the 30 year variety up 13%. Bonds in general were flat, as corporate and high yield suffered with the stock market.


The month started off with a bang on September 8, as the Swiss National Bank stunned the currency markets by setting a ceiling for the Swiss Franc against the euro in an attempt to prevent the strength of its currency from pushing its economy into recession. The "Swissie" has appreciated strongly over the course of 2011, and the SNB has now drawn a line in the sand: "With immediate effect, it will no longer tolerate an exchange rate in the euro against the Swiss franc below the minimum rate of SFr1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities."


The immediate reaction was an 8% decline in the franc, but the SNB had spent billions prior to the announcement to no avail. This time, the gloves are off and the first salvo in the "ugly" phase of the trade wars has begun. The Swiss are just not going to permit their vital export industry to be shut down as their products are priced out of the marketplace. They have made explicit their threat, and traders and investors are going to challenge them. (George Soros cemented his reputation in 1992 by "breaking" the Bank of England when they tried this very same maneuver with the British Pound. How much pain can the Gnomes of Zurich take? Time will tell.)

In an even more startling development, the US Fed announced on Sept. 15 that a global consortium of central banks, including Europe, England, Switzerland, and Japan stood ready to provide US Dollars as needed through year end to European banks. Long time market watchers know that where there's smoke there's fire, and this was not just a casual bit of news. It appears that Europe's "Lehman" moment is lurking, as some bank somewhere is unable to raise funds to operate and/or pay off maturing loans, especially of the short term repo variety. European blue chip companies have been withdrawing significant deposits from Euro banks, at the precise moment when the banks are unable to borrow or replenish capital through the sale of stock. A run on a major Euro bank is well within the realm of possibility, and it is the single greatest fear in the global investing community.

The Fed's swap arrangements are also meant to assuage fears of those who might wonder about the availability of Dollars should they wish to sell Euro based assets (a few Greek, Italian or Spanish bonds perhaps?) Many observers have concluded that this is just more "bailing out" money, and who, ultimately, is going to pay back these hypothetical Dollar loans and how? Perhaps the more important question is how long will the lines be open and funded? Years maybe?

The FOMC met on September 20-21, and they announced the next phase of their ongoing efforts to stimulate the economy, known by most as "Operation Twist". The Fed will be selling $400 billion worth of Treasury securities with less than 3 years to maturity, and using the proceeds to buy Treasuries with between six and thirty years maturing. The Fed's intent is to force down longer term interest rates to encourage borrowing (look for 4% 30 year mortgage loan rates coming soon to a lender near you). This action is entirely consistent with earlier academic writings by Ben Bernanke, who hypothesized that such an unorthodox policy could be employed in the event that traditional policy tools failed (i.e. lowering short term rates). We know now where the Fed stands - as we advised last month - they're out of bullets! It is logical to ponder now "how low could long rates go?" and "what's next if that doesn't help?" QE 3, 4, 5, or 6?

Meanwhile, Moody's and S&P were busy downgrading their long term credit ratings on countries like Italy and banks like Wells Fargo and Deutsche Bank in September. The deteriorating nature of their balance sheets was cited, and it is further evidence of the fiction that masquerades as truth when "substantial discretion" is still allowed bank managements to assign "current" market values to assets whose worth is permanently impaired. The downgrade race has just begun.

Lastly, precious metals suffered historic declines the week of September 23. To understand why, it is important to recognize that countries in Europe and banks that hold their bonds are on the ropes. The result has been massive selling of anything that has a profit (notably gold and silver) to raise Dollars and prepare for the next round of recapitalizing their balance sheets. Central banks were likely among the sellers of gold who all rushed for the exits at the same time.

The stampede was exacerbated by leveraged investors like hedge funds who had to make up for losses on stocks by selling gold, and trend following high frequency traders, who saw deterioration in the charts and sold first, asking questions later.
Increased volatility has also caused the CME Group to raise margin requirements for their gold and silver futures contracts, again causing speculators to exit (which is the intended effect - governments would love to crush the appeal of holding  gold and silver, which act as a store of value versus depreciating paper currencies).

Lastly, gold and silver are well publicized but relatively illiquid markets. It has been estimated that all the tradable bullion ever produced is still equal to less than 1% of outstanding publicly traded stocks and bonds. The "pig in the python" analogy is an apt visualization.

So it was a perfect storm for precious metals investors this month. To top it off, Austria announced that it will limit the purchase of gold bullion to 15,000 Euros per citizen. France apparently has a law that is meant to discourage the accumulation and sale of scrap metal, but could be applied the same way toward holders of gold and silver.

With so much current skepticism, it is unlikely that the long bull market is over in these metals, but for now, we expect to see a pause, or "consolidation" phase, develop. The duration of this consolidation will be linked to the direction of the US Dollar: if it rises strongly on the back of more Euro weakness, the pause will persist, and a resumption of the uptrend may not occur until 2012.

Germany voted on September 29 to continue to fund Europe's bailout fund, so the market wound up with a relief rally as the month closed. As usual, the details were given short shrift. Two takeaways from the German legislative act stand out though: 1.) no other packages or changes to existing loans will be considered going forward (i.e. Spain, Italy, Ireland et al) and 2.) the German Bundestag gets last word (i.e. veto) on any ECB, EU, or IMF decision. What the Germans want to do is strong arm private creditors (mostly Eurozone banks) into accepting big write-downs on their Greek bonds, while protecting their national banks. We are not sure the markets are in a wait and see mood; note the forceful sell-off in Euro bank stocks versus the S&P 500 since July:
 Euro Financials

So, as we enter the final quarter of the year, it is "risk-off" in spades. Markets are clearly telling politicians to get their act together. Economic indicators are flattish and some are rolling over. The chief economist of the ECRI (which officially designates "recessions" in the US) said at month end that a US recession was a certainty (did we ever really get out of the last one?).
Investors are in a big time selling frame of mind. We don't expect a turnaround tomorrow, but these are usually the best times to be a contrarian and freshen up the shopping list. A measured, well diversified approach, with a time frame greater than a month or two, is a good way to approach a skittish market, and that's what we intend to do. Thank you for reading our Journal, and have a great month!
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